Retirement account gaffes: Clients' biggest withdrawal mistakes

Baby boomers in the job market grapple with a persistent worry: What if I have a financial emergency that compels an early withdrawal from my retirement account? The income tax hit alone is painful but, unless an exception applies, the additional 10% penalty for those (usually) under age 59 1/2 applies salt in the wound.

The good news is that tax law provides exceptions to such penalties — for example, for employees over age 55 and age 50 who withdraw from company plans after separating from service. But it’s important to know that not every exception applies to every type of retirement plan.

Some apply only to distributions from IRAs, while others apply only to distributions from company plans. Other exceptions apply to both. The exception for higher education, for example, only applies to distributions from IRAs, not company plans. If the client has funds in a 401(k) and those funds are eligible for rollover, the advisor should first roll them over to an IRA and then withdraw from the IRA to qualify for the exception.

Even if the funds are correctly used for education, if they are withdrawn from the 401(k), the 10% penalty exception will not apply. In numerous U.S. Tax Court cases, taxpayers had to pay the 10% early withdrawal penalty because the exception they claimed did not apply to the plan that they took the distribution from. We see the biggest errors here with first-time homebuyers and in higher education in which exceptions apply only to distributions from IRAs and never from company plans.

Look at the case of Christine L. Gibbons v. Commissioner, for example. In this case, Gibbons, a schoolteacher, withdrew $67,553 from her 403(b) plan to pay for college education expenses. She paid the income tax but not the 10% penalty because she believed that the exception for higher education applied to distributions from company plans. It does not, as she found out when she lost in court.

In Keith Lamar Jones v. Commissioner, an accountant at Deloitte & Touche came to grief in Tax Court when he left his firm to begin full-time studies in a Ph.D. program using a distribution of $30,369 he received from his 401(k) to pay his education expenses and to purchase his first home. He wrongly believed he was exempt from the 10% penalty since the funds were used both for higher education and a first-time home purchase. Those exceptions only apply to distributions from IRAs, not from company plans. He also lost his case.

Here’s a pitfall that surprises advisors — and even some tax pros: A client can be in such dire straits that they have negative income for the year. In this case, an IRA distribution can be withdrawn tax-free due to low or negative income, even after the distribution. But the 10% penalty still applies even if there is no income tax.

In Matthew James Nasuti v. Commissioner, Nasuti took a $19,030 early distribution from his IRA after he was terminated from his job and used the money to help pay his living expenses while he was unemployed. Nasuti claimed that because his adjusted gross income was negative for 2008, the IRS was prevented from assessing 10% penalty. He lost his case, appealed and lost again. The Tax Court ruled that the 10% penalty applies to the amount of the early distribution that is required to be added to his gross income – even if this results in no taxable income. The 10% penalty is completely independent of the level of income, or lack thereof, for the year.

To qualify for the 10% penalty exception, expenses must generally be paid in the same year as the distribution. If funds are withdrawn from an IRA or company plan for medical bills, the bills must be paid in the same tax year as the distribution.

In Jeanette M. Kimball, et vir v. Commissioner, Kimball withdrew $17,222.69 from her qualified plan in 2000 to pay for medical treatments that began in 2000. Most of these medical bills, however, were actually paid in 2001. The Kimballs claimed that since they used the funds for medical expenses, they qualified for the medical expense exception to the 10% penalty, and therefore did not owe the $1,722 penalty assessed by IRS. The plaintiff lost because the expenses were not paid in the same year as the withdrawal from her plan.

Note that to claim the 10% penalty exception for medical expenses, the expense would have had to qualify as a deductible medical expense, meaning that it must exceed the income threshold for claiming the deduction, which has been increased to 10% of AGI for 2019. However, the penalty exception is still available even when a taxpayer does not itemize and instead uses the standard deduction, as many have opted to do since the tax reform changes beginning in 2018 went into effect.

Another tax trap to watch out for: Sometimes it’s necessary for savers to tap their IRA or plan funds to pay for a medical emergency. But since those distributions are taxable, they increase income, which in turn decreases the amount of the medical expense deduction and the amount of the medical expense that qualifies for the 10% penalty exception. This is one reason it’s important for advisors to set up tax-free sources of income, such as non-IRA funds — already taxed money, available for large medical bills.

What about hardship exceptions?

This one should be easy: There are no exceptions to the 10% early distribution penalty for financial hardships, except for special provisions for natural disasters like hurricanes, floods and wildfires. But it is often one that involves the most confusion, mainly because there are hardship exceptions available in many 401(k) plans. These exceptions only allow access to plan funds where they would not otherwisebe accessible. The tax and penalty still apply to these distributions. IRA funds are always available to be withdrawn but here, too, early withdrawals will be subject to tax and penalty, even if needed for a financial hardship other than those specific exceptions listed in the tax code.

What’s a disability?

This may be the toughest of all situations and one in which the 10% penalty exception is just as rigid. To qualify under the tax code’s definition of “disabled” for this provision, the person must be severely disabled, to the point that “ …he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.” – Tax code section 72(m)(7)

Translation: If you can work at anything, or expect to recover, the disability exception will not apply. Additionally, collecting a disability pension does not necessarily mean you qualify for the disability exception for early withdrawals from a retirement account.

In the sad case of Kathryn J. Gillette and Raif Szczepanski v. Commissioner, Gillette suffered from restless legs syndrome (also called Willis-Ekbom Disease), and started taking medication in the early 2000s and continued until 2008, at which time her insurance company required a change to a generic alternative. Over the years, the medication became less effective, and her doctor increased her dosage.

Unbeknown to Gillette, a side effect of her new medication was severe compulsive behavior, particularly compulsive gambling. Gillette’s life spiraled out of control. She stopped paying her mortgages, property taxes, maintenance expenses, and credit card bills. She received tax sale notices for her rental properties and a sheriff's warrant for unpaid state taxes. When the money disappeared, she borrowed from friends, took cash and credit cards from her husband's wallet, and eventually withdrew money from her retirement account in 2012.

Gillette and Szczepanski filed a joint 2012 return and reported an early IRA distribution of $104,001. They argued that they were not liable for the 10% penalty on the IRA distribution because Gillette had a mental illness caused by her medication. They contended that this qualified her for a disability exception to the 10% penalty. They lost and had to pay the 10% penalty. The court ruled that Gillette’s medical impairment was remediable and not a disability under IRC Section 72(m)(7).

IRS levy exception gone wrong

In extreme cases where IRS levies a retirement account for taxes owed, the 10% penalty does not apply. But the penalty exception does NOT apply to a voluntary IRA or plan withdrawal to pay IRS assessments.

A harsh exampleof this is found inthe case of Thompson, et al., v. United States. In 2012, Paul and Kathleen Thompson were in a tight spot. The married couple had outstanding tax liabilities for the 2002, 2003 and 2004 calendar years and the IRS had just issued a final notice indicating an intention to levy on their property. Looking to resolve the situation, the Thompsons withdrew over a million dollars from their retirement plan and paid the outstanding tax liabilities. However, since they both were under age 59-½, the distribution was subject to the 10% early withdrawal penalty, which in this case amounted to $122,784.

They argued their retirement plan distribution fell under the IRS levy exception since (a) the money was used to settle an outstanding tax bill, and (b) the distribution came after the IRS issued a final notice and Intention to levy. The court disagreed and upheld the penalty because no levy was actually filed on the retirement plan. Instead, the Thompsons took a voluntary distribution. In the end, not only did they lose over a $1 million dollars in retirement assets to satisfy an old tax debt, but the additional $122,784 due to the 10% early withdrawal penalty was upheld.

Previous cases, and the tax code itself, make it clear that the exception does not apply unless the retirement account itself is levied, and the IRS triggers the distribution.

Prove it!

If a distribution is taken for an expense that qualifies for the 10% penalty exception, like anything else when it comes to taxes, it must be proven. In Marlon G. Dasent et ux. v. Commissioner, the Tax Court ruled that the couple could not prove that IRA distributions were used for education expenses, even though they provided billing statements and emails for their children’s college expenses. But these items did not show that they used any IRA distributions to pay education expenses. The court dismissed these items citing concern “as to the authenticity” of them. To qualify for the 10% penalty exception you must be able to prove that IRA distributions were timely used to pay the expenses claimed.

Advisors must be familiar with the various exceptions to the 10% early distribution penalty and how they apply. It’s knowledge that can help a client when they need it — and you — the most.